A capital charge is the return a project must realize to cover the cost of the capital it uses. It is given in units of currency rather than as a percentage. This figure is based on the minimum return that investors demand in exchange for the use of their funds. If the returns of a project do not meet this minimum threshold, then it may not be worthwhile to carry it out even though it may have positive returns.
The capital charge depends on the return that investors expect on each class of capital. It is found by multiplying a project’s invested capital by a percentage. This percentage is a weighted average of the investors’ expectations. Before calculating the capital charge, an analyst must determine both of these numbers.
Invested capital is composed of a variety of capital sources. For example, if an investor buys a share of stock from a company in an initial public offering, he contributes the purchase price of that stock to the company’s capital. This is called equity capital. The company can also sell bonds, which create loans from investors to the company, and this type of capital is debt capital. The total amount of invested capital can be found by taking the company’s capital listed on its balance sheet and adjusting it so it also shows the capital not reported there.
The percentage by which the invested capital is multiplied is called the weighted average cost of capital, or WACC. Each type of capital has a different cost because investors treat each class of investments differently. Analysts must determine the cost of each class, and then create an average that is weighted according to how much of the company’s invested capital comes from each class of capital.
The cost of debt is easy to determine because it is outlined by the company in the 10-K reports it submits to the Securities and Exchange Commission. It can also be approximated by looking up a company’s debt rating, which is assigned by an independent rating agency, and the rating’s associated estimated cost of debt. The cost of equity must be calculated based on theory. For example, an analyst could use the formula prescribed by the capital asset pricing model to find the return that the asset would have to give an investor to compensate him for the risk associated with it.
The capital charge is significant because it is used to calculate another financial concept called economic profit. This is the net operating profit after taxes, or NOPAT, minus the capital charge. It shows whether the project in question has high enough returns to make it worthwhile to investors.
